The World Economic Crisis - Alliance of Liberals and ... · Liberal International - The world economic crisis Prepared by Juli Minoves-Triquell, LI Vice-President in the Bureau 5

The World Economic Crisis

An essay on its origins, characteristics and possible outcomes

from a liberal perspective

Prepared by Juli Minoves-Triquell Minister, Government of Andorra

Vice-President in the Bureau of Liberal International

on a mandate from the 181st Executive Committee gathered in

Strasbourg (France) on the 25th of January 2009

presented at the 182nd Executive Committee gathered in Vancouver (Canada) on the 2nd of May 2009

Liberal International - The world economic crisis

Prepared by Juli Minoves-Triquell, LI Vice-President in the Bureau 2

INDEX

I. Introduction ............................................................................. 3

III. The Question of Property........................................................ 18

IV. Economic Self-Interest ........................................................... 21

V. What the Crisis Means for Liberalism ...................................... 24

Appendix 1: Origins of the crisis ................................................... 33

• Unparalleled expansion and unbridled optimism. .........................................................33

• Lack of perspective of the economic profession. .............................................................34

• Blind belief in the strength of large financial and economic institutions. ..............34

• Failure of statal regulatory supervision. ............................................................................35

• Incapacity of management, boards, and investors to assess real risk. ...................35

• Accumulation of public and private debt. .........................................................................36

• Contagion effect. ........................................................................................................................36

• Lack of preparation among monetary authorities. .........................................................36

• Low interest rates and high world growth.........................................................................37

• Failure of market discipline. ..................................................................................................37

• Lack of checks and balances.................................................................................................38

• Size and centrality of the shadow banking system. .......................................................38

• Rating agencies. .........................................................................................................................39

• Compensation schemes. .........................................................................................................39

• Procyclical regulatory practices and regulations. ...........................................................40

• Accounting practices................................................................................................................40

• Macroeconomic settings..........................................................................................................40

• Global imbalances.....................................................................................................................41

• Poor forecasting ability on the part of international financial organizations

and governments. ...............................................................................................................................42

• Cross border resolution and burden sharing among national regulators. .............43

• Access to adequate liquidity and financing. .....................................................................43



I. Introduction

The economic crisis that has roiled the world over the past nine

months gives a new meaning to a phrase, so beloved of philosophers

and sociologists, “a world historical event.”

As a “world” event, these months have revealed, with shocking

ferocity, the interconnectedness not only of national economies and

economic domains, but also of the political and moral beliefs that

surround capitalism. Sub-prime loans in certain American states set

off a chain reaction that spread across the economic spectrum—from

the insurance industry and the automobile industry to commercial

and investment banking—and across continents, as countries as

distant as Ireland and Iceland, Spain and China experienced economic

upheaval and crisis This global event has triggered a profound

meditation on the perils of a global economy.

As a “historical” event—the economic crisis raises a number of

pertinent questions from a liberal perspective. In what sense is this

crisis historical? Is it a repetition of earlier bubbles—from the South

Sea bubble of 1720 to the Great Depression of the 1930s—or is it

something radically new? Moreover, how should liberals interpret

these moments of economic collapse? Are they ruptures exposing

fundamental structural weakness in capitalism? Are they events in



which the system recalibrates itself and expands its interests? Or are

they events in which the system simply demands to be recalibrated?

Some have traced the crisis to the climate of easy borrowing created in

the United States by Alan Greenspan, the chairman of the board of

governors of the Federal Reserve, in response to the collapse of the

hedge fund Long Term Capital Management in the late 1990s and the

bursting of the dot.com bubble that inflated the housing market

bubble. Others (again tracing the origin of the crisis to the United

States) suggest that the repeal of the 1933 Glass-Steagall Act, which

was designed to limit speculation by separating commercial from

investment banking, created an environment that allowed reckless

lending. Others regard the crisis as symptomatic of a fundamental

instability in the type of finance capitalism that has developed in

America, Britain and some other Western countries. These accounts

are neither mutually exclusive nor exhaustive. But economics alone

may not provide a satisfactory understanding of the events of the past

year, for they include shifts in geopolitics that go beyond economic

performance. Market economies are not controlled solely or even

chiefly by economic theories; they rely on ideas about right and wrong,

fairness in society, and orderliness in the world. For that reason, a

liberal analysis that is at once systemic and historical, particular and

global, must also emphasize the extent to which political ideologies

and economics shadow one another.



II. Political and Economic Underpinnings of Liberalism

Obviously, we can find historical parallels to the current situation that

are relevant. Such parallels can still trigger debate. For example, the

first European bankers were Italians from Genoa, Venice, Pisa,

Florence and Lombardy, who began their activity in the twelfth

century, establishing offices all over the continent. They lent huge

sums of money to the kings of England and France, even to the point

of financing the Hundred-Years War. The sovereigns, however, never

repaid their debts and the banks went bankrupt. In those days there

were no governments willing to cover their liabilities. When Lehman

Brothers also went bankrupt there were those who considered it a

mistake not to have saved it. But many liberals no longer favor the

idea of dedicating vast quantities of money to save banks that did

business like unscrupulous gamblers. However, I believe that it is

important as liberals not to lose sight of our foundational principles in

the course of debating our response. Ours is a tradition that holds

values that must not be forgotten in the urgent climate of crisis.

For classical greek philosophers, and to a certain extent for thinkers

like Jean-Jacques Rousseau, liberty primarily meant the right to have

a voice in the collective process of decision-taking. Livius, Tacitus and

Cicero are Roman thinkers and orators that built concepts around

more advanced ideas of individual liberty. In modern times, however,



liberty has come to be understood as a protected sphere of non-

interference with personal freedoms in which independence can be

regulated by the law. Hobbes and Spinoza were the first modern

apostles of liberty in the form of individualism. Their formulation of

human liberty, power, and self-interest expanded the limiting

boundaries imposed by previous concepts of politics.

Generally, the conception that free individuals could form the

foundation for a stable society is dated from the work of John Locke,

whose Two Treatises on Government established two fundamental

liberal ideas: economic liberty, meaning the right to have and use

property, and intellectual liberty, including freedom of conscience.

Locke saw the earlier idea of natural rights as "life, liberty and

property." To him, property was more important than the right to

participate in government and public decision-making and he feared

that giving power to the people would erode the sanctity of private

property. He conceived of a society of human beings equal under the

law, gathered without a common purpose, who still shared respect for

the rights of other human beings, but he was perceptive in recognizing

the while human liberty and independence presupposes private

property safely protected by the rule of law, the desire to expand

property required certain restraints. Liberty, in other words, did not

guarantee abusive privileges to any individual. This fundamental point

has been obscured in recent bailout procedures although underscored

in the public outcry against funds expended on corporate luxuries,



bonuses, and lobbying efforts.

The British contribution to the development of liberal ideas was

seminal. Political liberties gained during the “Glorious Revolution” in

the United Kingdom influenced French thinkers such as Montesquieu

and helped Benjamin Constant and Alexis de Tocqueville reformulate

an understanding of political and economic liberty. Both Constant

and Tocqueville worried about the future of liberty—Constant on the

basis of his reading of the French Terror after the revolution and

Tocqueville preoccupied by the limits on individualism that the

tyranny of the majority could impose in a government by the masses.

The first modern liberal state, the United States of America, was

founded on the principle that "all men are created equal; that they are

endowed by their creator with certain unalienable rights; that among

these are life, liberty and the pursuit of happiness; that to insure

these rights, governments are instituted among men, deriving their

just powers from the consent of the governed." It is a commonly

known fact that Thomas Jefferson substituted the famous phrase “life,

liberty, and the pursuit of happiness” for the words “life, liberty and

property” contained in an earlier draft. The Federalist papers offer a

contrast with French liberal writings in their understanding of human

imperfections that permeates their concept of liberalism. Again, we

find recognition of the potential for abuse within the exercise of

individual freedoms. Thus, an interesting tension between the



ownership of property and the pursuit of happiness lies at heart of

liberal politics. A tension, I might add, that this economic crisis

brings into higher relief.

We find in David Hume’s Treatise of Human Nature (1739) a link

between political and economic liberalism: he notes the restricted

benevolence of human beings, as well as the permanent scarcity of

resources sufficient to satisfy human needs, and from these two

postulates he infers the causes for the appearance of the basic

principles of justice. He acknowleges three fundamental laws of

nature: stability in possessions, their transference by consent, and the

keeping of promises. “I shall therefore venture to acknowledge,” he

declared, “that not only as a man, but as a British subject I pray for

the flourishing commerce of Germany, Spain, Italy and even France

itself.” This acknowledgement of a need for global progress rather

than protectionist exclusions prefigures the current liberal stance.

In The Wealth of Nations (1776), Adam Smith gave shape to the central

ideas that govern a market economy. His observation of people,

institutions, firms, and households, convinced him that economic

growth was best served by the free operation of markets, in contrast to

the regulations of internal and external trade that had favored the

mercantilists, and he postulated that the epochs of human history

would culminate in a free market economy. At the same time, he

recognized that government should assume tasks that could not be



entrusted to the profit motive, such as preventing individuals from

using force or fraud to disrupt competition, trade, or production.

Smith articulates the liberal idea that changes in the economic system

are parallel to changes in the political structure and that a free market

system goes hand in hand with a political system that guarantees civil

and political liberties. In a systematic and universal way, he

formulated a theory of methodological individualism which implied

that individual human agents determined any social outcome. For

Smith, the wealth of nations originated in the productivity of labor.

But the division of labor on which productivity depended was in its

turn based on the extent of the market and capital accumulation.

At the end of the Napoleonic Wars, the reign of liberalism was

relatively unchallenged. Classical liberalism evolved in the hands of

liberal thinkers such as Jeremy Bentham, who gave it a new twist. In

many respects, Bentham was a classical liberal, but he advanced the

idea that social institutions could be the object of rational redesign, an

innovation that led later thinkers to elaborate illiberal and

interventionist prescriptions that moved far beyond his original,

merely utilitarian, concepts. His disciple James Mill worked on a rigid

rationalist defense of democracy in his Essay on Government. His

son, John Stuart Mill, was in a sense closer to classic liberalism than

either his father or Bentham, but in the field of economics, he flirted

with some socialist schemes and helped justify British interventionist

and statist policies of the end of the nineteenth century. However,



Mill articulated fundamental principles of what might be called

cultural liberalism that are directly relevant to the current crisis. In

1859, in his essay “On Liberty,” he claimed that neither physical nor

moral good would justify interfering with the liberty of another person.

The only rightful exercise of power against a person’s will, therefore,

would be to prevent harm to others. In other words, a desire for profit

or the acquisition of property must be pursued within defined ethical

limits.

David Ricardo strengthened the case for liberal laissez-faire

economics. In his theory of comparative advantage, he demonstrated

that international trade benefits all trading economies and increases

world output. Using Ricardo’s theory of international trade, Mill was

able to analyse the division of gains among trading partners and came

close to developing the concept of price elasticity of demand. While

rejecting the socialist condemnation of private property and

competition, at times he advocated strong intervention of the state in

the economy. Thus, while he defended the classical tenets of

liberalism, he justified intervention by the state in order to counter the

injustices he observed in the capitalist system. For Mill—and this is

perhaps his most critical insight for addressing contemporary issues—

individual improvement and self-fulfillment were as much a basis for

his philosophy as liberalism was a basis for his economic beliefs.



Alfred Marshall is probably one of the most influential neoclassical

economists. He acknowledged different strains of methodological

approach to economics. Going beyond a purely mathematical,

historical, or politically oriented method, he recognized the

complementarity in all of these approaches. He avoided controversy

over whether prices resulted from supply or from demand alone to

apply marginal analysis to the complex issues of price determination.

With Smith and John Stuart Mill, he analysed the behavior at the level

of the household and the firm. Conceiving of free markets as a mode

of working out economic conflicts, he set up the framework for today’s

partial equilibrium microeconomic theory although modern

microeconomics has moved away from Marshallian economics through

the work of John Hick and Paul Samuelson, with later contributions

by Arrow and Debreu. The Chicago School of economic analysis

continued to be based on Marshall’s work but with a much more

pronounced pro-market approach.

In the United States the Great Depression shook public faith in

"laissez-faire capitalism" and "the profit motive," leading many to

conclude that the unregulated markets could not produce prosperity

and prevent poverty. Troubled by the political instability and

restrictions on liberty that they believed were caused by the growing

relative inequality of wealth, many liberals argued for the creation of a

more elaborate state apparatus to serve as the bulwark of individual

liberty, permitting the continuation of capitalism while protecting the



citizens against its perceived excesses. Key liberal thinkers of this

persuasion—John Maynard Keynes, in particular—had a significant

impact on liberal thought throughout the world. Liberal International

was heavily influenced by Keynes, as were the Liberal Party in Britain,

particularly since Lloyd George's People's Budget, and the Oxford

Liberal Manifesto of 1947 of the world organization of liberal parties.

In the United States and in Canada, Keynesianism influenced

Franklin D. Roosevelt's New Deal and led social liberalism to be

identified with American liberalism and Canadian liberalism. But the

liberal position on economics was not a unified one, as evidenced by

the positions adopted by the Austrian School in contrast to those

favored by American liberal economists and these differences persist

in liberal thought in the United States and in Europe.

One of the central questions of the twentieth century—one that

interested economists everywhere—was whether socialism or

capitalism could better allocate resources. Keynes was not a socialist,

but he was criticized from both sides of the political spectrum, some

thinking he wanted to dismantle capitalism, those to the left beliving

that he was its apologist. In his formulations of economic policy, he

defended individualism and the use of self-interest to achive efficiency

and innovation. “But above all, individualism,” he wrote, “if it can be

purged of its defects and its abuses, is the best safeguard of personal

liberty in the sense that, compared with any other system, it greatly

widens the field for the exercise of personal choice. It is also the best



safeguard of the variety of life, which emerges precisely from this

extended field of personal choice, and the loss of which is the greatest

of all losses of the homogeneous or totalitarian state.”

Keynes’ General Theory changed the existing focus on microeconomics

of resource allocation to macroeconomic business fluctuations.

Recognizing instabilities inherent in capitalism, he concluded that the

automatic working of the market produced equilibrium at less than

full employment, and advocated investment spending to determine the

level of economic activity. Monetary and fiscal policies advanced by

Keynesians required little direct government intervention in the

economy and they were put to use in the United States, but Keynesian

policies were contested by monetarists, who countered that he did not

account for the role of money. A new macroeconomic model emerged

and later new literature on the microfoundations of macroeconomics

was produced to reconcile micro- and macro- theories.

Friedrich von Hayek believed that Keynesian analysis confered a

causal power on statistical measures that they do not have in the real

world. He elaborated on the negative response of his compatriot

Ludwig von Mises to the question of socialism’s allocation of

resources, but he also argued that socialism was incompatible with

economic and political freedom. Dismissing any objective theory of

value, Hayek maintained that economic value is confered by the

preferences and evaluation given by individuals. His subjectivist lens



refused to acknowledge the theory of general equilibrium and

questioned the validity of systems of global economics. The Austrian

School of economic thought regained momentum in the recession of

the seventies, when it postulated that inflationist monetary policies

would fail because they modified the expectations of the governing

class. Monetary expansion, the Austrians argued, could not stimulate

the economy unless its results were to be unexpected. Therefore, once

inflationist policies became a given, they could not have an

expansionist effect on the economy. In the end, the Austrian school

came to recommend the classical economists’ solution to economic

depression and collapse: government should pull away from the

economy and restrictive practices at the border should be diminished.

The arguments of the Austrian School contradicted those of the

Chicago School, as well as Keynesian economists. Milton Friedman,

for example, proposed monetary control as the way to achieve stable

growth. He argued that the Great Depression was not a result of

"laissez-faire" capitalism but of too much government intervention and

regulation upon the market. For him, the government regulation that

occurred before the Great Depression (including heavy regulations

upon banks that prevented them from reacting to the markets'

demand for money and the creation of a fixed currency pegged to the

value of gold) prevented the country from reacting to currency

demand, thereby creating a run on the banks that the banks were

unable to handle. Fixed exchange rates between the dollar and gold



also created deflationary pressures. To address the crisis, the

government inflicted pain upon the American public first by raising

taxes and then by printing money to pay debts (thus causing

inflation). The combination helped to wipe out the savings of the

middle class.

Significantly, modern macroeconomics has focused primarily on

business-cycle theory as well as on monetary and growth theory. One

of the first economists to focus on business cycle theory was the

French physician and economist Clement Juglar. In 1889 he wrote:

“The periods of prosperity, crisis, liquidation, although affected by the

fortunate or unfortunate accidents in the life of peoples, are not the

result of chance events, but arise out of the behaviour, the activities,

and above all out of the saving habits of the population, and the way

they employ the capital and credit available.” These factors, of course

are all implicated in the current crisis. But Joseph Schumpeter also

addressed the role of business and human endeavor in his theory that

the principal agents of economic growth are non-economic. They are

found, he argued, in the institutional structure of society and the

activities of entrepreneurs who are able to grasp the potential of a new

invention and exploit it for personal gain. As long as government

institutions stress laissez-faire markets, an innovative entrepreneur

can thrive and the economy can grow. But Schumpeter feared that

successful firms would become more risk-aversive as they grew in size

and instead of rewarding innovative entrepreneurs would be run



bureaucratically. Ownership would be removed from the concerns of

the company. In this evolution, which is one of the contextual

elements of the current crisis (with its attendant emphasis on CEO

bonuses, creative accounting practices, and insider trading to

manipulate stock values), he foresaw the removal of a large part of

suport for capitalism. Schumpeter’s perception is based

fundamentally on the idea that losing the value of stewardship also

stifles innovation.

Perhaps the greatest tension now within the context of Liberal

International is between those who argue for "creative destruction," in

Schumpeter's phrase, and those who argue for "Keynesian" stimulus

of demand. Although they are not mutually exclusive ideas, some

parties, particularly those that rely on a general national vote, are

likely to emphasize creative destruction while others, whose

representation is more locally based, are likely to emphasize the need

to protect particular industries and regions through stimulus

packages and the protection of local industry. This is one of the

essential debates we must pursue and one of the greatest challenges

facing international collaboration.

The 1970s were prolific in the rebirth of liberal ideas in political

philosophy. John Rawls in his A Theory of Justice (1971) developed a

liberal concept of social organization very much linked to the classical

liberal concern for individual liberty in a constitutional order governed



by the rule of law. Robert Nozick underlined the necessary connection

between economic freedom and personal non-economic freedoms,

such as freedom of expression and way of life. His postulates directly

contradict the rightist use of the free market by conservatives in the

United States. However, the 1980s were characterized by a strange

dichotomy between economic and political liberalism. Conservative

political leaders coopted the ideas of the new classical theorists of the

economy, such as Hayek and Friedman, and free market policies came

to be associated with conservatism. However, the application of

classical liberal policies became associated with non-liberal policies in

the field of civil and personal liberties.

John Gray notes that liberalism is the political theory of modernity; a

political theory of modern individuals concerned with liberty and

privacy, and with the growth of wealth and of invention and

innovation; which conceives a machinery of government indispensable

for civil life but sometimes posing a threat to the civil life it aims to

safeguard. It has been attacked by conservatives as well as by

socialists, who seem to converge, he believes, in certain aspects of

their criticism of liberalism. Both socialism and conservatism have in

their own way tried to reject the liberal concepts of a civil society in

favor of their respective understandings of a moral community. At one

point in their ideological development, they both conceived of

liberalism as only a phase in social development. However, apart from

vague references, neither conservatism nor socialism have been able



to forecast a satisfactory theory of what state of affairs they would

prefer in a post-liberal world. In certain countries, the breakdown of

liberalism after World War I created grotesque and in the end tragic

totalitarian states and led to major disasters and genocides. Some

kind of idealized return to communitarian value systems like those of

the middle ages, whether in a socialist perspective or in a conservative

one, does not relate to the individualism assumed by many to be the

basis for economic and political freedom in our modern world. The

current economic crisis must be viewed in this perspective: a crisis of

growth, of stewardship and of classical liberal ideals gone awry. Many

of its origins and consequences have been tackled by economists in

the past, and this suggests that the present crisis can be understood

and countered with remedies found in the evolution of economic ideas.

III. The Question of Property

One of the basic ideas of the early liberal thinkers was contractual:

individuals made agreements and owned property. Gradually, the

liberal tradition introduced the idea that voluntary consent and

voluntary agreement were the basis for legitimate government and

law. Thus traditionally, economic liberalism has supported the

individual rights of property and freedom of contract, without which, it

argues, the exercise of other liberties is impossible. And as long as no

coercion is used, economic liberalism accepts the economic inequality



that arises from unequal bargaining positions as being the natural

result of competition. Twentieth-century economic liberals stressed

the importance of a free market and free trade and sought to limit

government intervention in both the domestic economy and foreign

trade. Social liberal movements often agree in principle with the idea

of free trade, but maintain some skepticism, seeing unrestricted trade

as leading to the growth of multi-national corporations and the

concentration of wealth and power in the hands of the few.

Although the events of the past year have returned Keynesian

economics to favor, and the policy of reducing the cost of borrowing to

near zero while expanding debt-financed government spending on a

large scale resembles the proposals Keynes advanced in the 1930s, it

is not clear whether he would approve of their application today.

Their goal is to encourage people to spend and borrow more, a

strategy that attempts to return to debt-financed consumption. One

challenge to realizing this goal is that developed world economies and

many in the fast developing world—the U.S. is a significant

exception—will rely on older people to provide the demand-pull and

the labour supply to draw economies out of recession. Yet during

recessions, older people leave the labour force in disproportionate

numbers and they do not return, creating problems of long-term

depressed demand and a lack of key skills and general labour supply.

Critics also point out that the strategy of a return to debt-financed

consumption cannot work without sparking inflation at some point in



the future. Large sections of the population, whose wealth has

already been depleted by the decline of the housing and stock

markets, could find it shrinking further as the value of money is

reduced. And large sections of the population already occupy an

economic position of impoverishment or need in extreme contrast to

the situation of the most wealthy. The social contract—the liberal link

between regard for the rights of property and regard for ethical

limits—has in many ways been broken.

In one sense, the shift from preservation of property rights to the

pursuit of happiness has entangled the definition of happiness with

ownership of things and economic status, turning the liberal

individual into a consumer indifferent to limitations of prudence or

concern for others. Often the basic values of a capitalistic economy are

negative: become rich at all costs, gain wealth to obtain power,

selfishness, prevarication over the weakest and over those unable to

produce, such as the elderly and the unemployed. These un-values

were the engine of a market without rules and of un-braked financial

anarchy, severing all ties with the productive system, with the State,

with laws, and morality. The pursuit of happiness has become the

pursuit of material accumulation, whether in terms of bonus rewards,

corporate jets, plastic decorations, or luxury brands.

The ethos underlying earlier property ownership also involved a sense

of stewardship that is foreign to present-day consumption of



resources. The level of consumption achieved in recent decades has

run up a large debt to the planet. Our natural capital is reaching a

state of global crisis equivalent to the turmoil in the financial markets.

In 1929, when the run on the banks tilted the American economy

toward the Great Depression, Keynes wrote, “It will take 100 years

before the economy reorganizes itself on more positive values, such as

solidarity and understanding towards the most unfortunate and the

needy, placing human beings at the top of every economic activity and

establishing ethical finance to be at the service of human and social

progress.” Today, we recognize that the economic reorganization he

envisioned has failed to occur.

IV. Economic Self-Interest

Contemporary liberalism has come to represent different things to

Americans and to Europeans: in the United States it is associated

with the welfare-state policies of the New Deal program of Democratic

President Franklin D. Roosevelt, while in Europe liberals more often

adopt a conservative political and economic outlook. American

liberals endorse regulation for business and a limited social welfare

state. In Europe liberalism is characterized by beliefs in free trade and

limited government. The global nature of the current crisis tests all

these assumptions.



In the wake of the economic crisis of the 1990s, American economist

Lawrence Summers asserted that well-capitalized and supervised

banks and reliable, transparent corporate accounting had protected

the United States. But in reality, deregulatory zeal had empowered

bankers to develop highly sophisticated financial markets. The

temporary paralysis of the world credit markets when the Long-Term

Capital Management hedge fund collapsed in 1998 should have

indicated that this deregulated system, with its highly leveraged

players and global capital flows, was becoming dangerously fragile, yet

ironically the close escape from calamity made investors more

complacent. It is now clear that by making ever-larger gambles, elite

American financiers, with implicit government backing, played a

central role in creating the current crisis and are using their influence

to prevent rapid reforms needed to pull the economy out of its

collapse.

Like the failure of the Iraqi war, the economic crisis is costing America

some of its credibility, and with it some of its ability to lead, but the

United States was not the only nation in which banks ran wild.

Stronger social safety nets mean that Europeans may experience less

human suffering than their American counterparts, but economic and

financial troubles have afflicted countries that only a few years ago

were being praised as “economic tigers” or “economic miracles.” In

these countries, an inrush of capital created an illusion of wealth, just

as it did for American homeowners.



And damage spreads. In America, for example, the housing bubble

mainly took place along the coasts, but when the bubble burst,

demand for manufactured goods collapsed—and that has taken a toll

on the country’s industrial heartland. Europe’s bubbles also mainly

occurred around the continent’s periphery. Spain, for example, has

been called the continental Florida and the situations are similar: the

huge speculative housing boom that buoyed up its economy is over

and new sources of income and employment must be found to replace

lost jobs in construction. Meanwhile, thanks to a plunge in exports,

industrial production in Germany—which never experienced a

financial bubble but is Europe’s manufacturing core—is falling

rapidly.

Moreover, in this globalized financial system, a crisis that began with

a bubble in Florida condos has caused monetary catastrophe in

Iceland, and countries linked by the euro are tied to the inflationary or

deflationary health of the European economy as a whole. Thus Spain,

unable to improve competitiveness by devaluing its currency, is being

forced into the painful process of cutting wages. China is

experiencing another type of linked monetary problem. Having chosen

to keep the value of the yuan more or less fixed in terms of the dollar,

its trade surpluses resulted in inflows of foreign capital, much of it

invested in safe but low-interest U.S. Treasury bills. Now China’s

exports have fallen and selling dollars would drive the dollar down and



trigger a big loss of capital. The world in which China could save

more than it invested and dispose of its excess savings in America is

gone. Wrenching changes will be needed to deal with this global crisis

and those changes will affect us all.

V. What the Crisis Means for Liberalism

With hindsight, we can tally up the causes of the crisis (see the

discussion in Appendix I). They include unparalleled expansion,

unbridled optimism, lack of perspective in the economic profession,

blind belief in the unbreakable strength of large financial and

economic institutions, the failure of regulatory supervision,

unwillingness to assess real risks, and accumulation of debt (both

public and private) in an environment of expanding optimism.

Failures, in other words, of stewardship.

In this context, the core liberal belief in the benefit of open markets

requires examination into the extent to which the culture of always

wanting more contributed to this crisis, for stewardship is

incompatible with sacrificing the environment either for the sake of

exceptional profits in industries that depend on the aggressive

consumption of natural resources or to feed the desire to preserve (or

emulate) increasingly affluent lifestyles. That is not the same as



saying that the concept of markets is outdated or that protectionism

offers a magic solution to our problems. In fact, competition

stimulates the innovation that can lead out of the crisis. On the other

hand, it seems inevitable that banks must deleverage and be subject

to stricter governance and compensation arrangements in the future.

Some may object to the idea of more regulation, but perhaps the

essential question is whether governments possess the political will to

collaborate in order to achieve a solution.

Let us look first at the strength of political will in the United States.

In effect, the US administration appears ready to shower benefits on

everyone who made the mistake of buying the banks’ so-called “toxic

assets.” It’s true that some benefits would trickle down to shore up

the balance sheets of key financial institutions. But most would go to

people who don’t need or deserve to be rescued. Not only is the plan to

unfreeze the credit markets vague and potentially inadequate, laying

out trillions of dollars to bring the financial system back to health

adds to already serious concerns about the deficit. Officials appear to

have seized on this solution because it’s very hard to rescue an

insolvent bank without taking it over, and politically, even temporary

nationalization appears unthinkable. Another danger is that once the

economy begins to recover, the urgency for financial reform will be lost

and those making easy money again will lobby against anything that

interferes with their interests. Nor were politicians and economic

officials approving the stimulus plan able to transcend the



conventional prejudices against deficit spending and making

significant changes. Stimulus packages with short-term benefits in

stimulating demand and can be put into effect immediately

(the "shovel-ready" initiatives, for example, built into the US stimulus

package) also need to project a long-term effect on improving

infrastructure and the environment. The EU's Enterprise Directorate

is looking to identify types of innovation in which short-term

investment has a long-term benefit. Extending IT network capability

would be one example. In Britain, the London School of Economics

and the Treasury have been working on green aspects of stimulus

packages with long-term benefits in improving the environment and

tackling climate change. In the US, stimulus plans including

infrastructure and “green jobs” acknowledge this necessity for long-

term investment.

Most economists agree the plan that emerged from Congressional

compromise was weaker and contained more tax cuts than it should

have (and even so failed to gain broad bipartisan support). On the

other hand, President Obama’s proposed budget would set America on

a fundamentally new course in terms of stewardship. It represents a

huge break with policy trends over the past 30 years by allocating

$634 billion over the next decade for health reform (paid for in part by

halting the privatization of Medicare and eliminating overpayments to

insurance companies) and it projects $645 billion in revenues from

the sale of emission allowances (signaling that after years of delay and



denial, this administration is ready to address the problem of climate

change).

Although Europe’s problems are equally grave, the political will is

equally fragile and the focus of debate is somewhat different. For

example, politicians will not admit to protectionist policies. Instead

they present them under better colours, for example, as the need to

use national money to protect national jobs. Strong leadership is

essential to avoid the temptation to offer "buy European" or "buy

Dutch" as a solution. The liberal position would hold to the principle

that despite radically different market conditions, the single market

must be guarded like the jewel of the EU family. That implies a

refusal to bail out structurally inefficient companies and thus place a

massive tax burden on future generations. Here is evidence for the

contrast between American and European liberalism.

European governments have begun to improve interbank lending with

bank guarantees and recapitalisation. The need for a consistent and

coordinated approach among the EU countries is non-negotiable, but

member states must be resolute to reduce uncertainty. Otherwise the

risk is the perpetuation of failed business models, ruin of public

finances, entrenchment of competitive distortions, an imperilled single

market, and the loss of a viable banking market after the crisis is

resolved. Although implementation involves difficult questions, for

actions must be timely, targeted, and transparent as well as



sustainable from a budgetary perspective, the demand for

transparency and a willingness to restructure seems more evident in

Europe than in the United States.

If American economists argue that the Obama administration’s

stimulus plan was too small to address the depth of the crisis,

European actions have been proportionately smaller, in part because

officials remain complacent. Paul Krugman, with typical candor,

excoriates this lack of fiscal action, blaming structural weaknesses

inherent in the absence of any government in a position to take

responsibility for the European economy as a whole or take political

risks for the benefit of another country and the lack of unitary support

for the European Central Bank, which owes allegiance to sixteen

countries that disagree among themselves.

The International Monetary Fund, which has a leadership mandate,

near universal membership, and a blend of macroeconomic and

financial expertise, is instituting steps to increase global coordination.

A new warning exercise, for example, will bring together scattered

macro-financial expertise, piecing together macroeconomic and

financial sector developments into a big picture that takes into

account cross-country spillover effects and can drill down on key

threats. It is also reviewing its lending framework to make sure it is

well-suited to members’ needs. However, the bureaucratic ways and

rigid power structures that characterize the IMF have shifted the

policy debate towards smaller, more flexible groups, including to the



G-20 and the FSF. Yet these smaller groups have their own problems

of legitimacy and capacity for follow-up. Making decision-making

more accurately reflect today’s global economic landscape would

require a further rebalancing of voice and representation among IMF

members.

The extent to which financial regulation can be made both

international and binding remains in question. Clearly, a common

currency requires stronger common rules than a looser association,

but while recognizing the need for international cooperation the

desirability (or even the possibility) of over-riding national control of

regulation with pan-national structures undoubtedly is an issue that

will cause debate. Such structures may be more efficacious when

combined with national and, particularly in the EU case, trading bloc

regulation.

The world will not be the same at the end of the current crisis.

Important changes will reflect new attitudes toward stewardship,

including a new industrial revolution impelled by ecologically

sustainable development. In many countries, research for new

production systems, conservation, and the thrifty use of energy are

already expected to be a means for creating new jobs. As one

example, the world’s fifth exporter of petroleum, the United Arab

Emirates, has commenced a multi-billion dollar project to make their

capital, Abu Dhabi, the international center for renewable energies.



The fundamental stages of human economic development have always

coincided with the ability to capture new sources of energy: fire, wind,

water, sun, natural gas, petroleum. Acceleration of development in

the last two centuries was made possible through a parallel

acceleration of energy production, using new sources and applying

more advanced technologies. But solutions cannot rest on technology

alone; in many ways heightened financial technologies abetted the

current monetary crisis and a variety of biological innovations have

the potential to alter the world’s commodity markets. And a rapid

return to the rate of economic growth of the past decades—the aim of

many policy makers around the globe—would increase the emissions

of greenhouse gases that are altering the climate. Moreover, in this

urgent crisis, political pressures run the danger of restarting economic

growth by any available means. But returning to the levels of

consumption that characterized the recent past will run up an

environmental bill that the planet will surely collect.

This is why liberalism, in the sense not only of economics but of the

classical regard for economic and social progress for all, will become a

crucial force in the process of solving the crisis. To rebuild a new

economic system, it will not be enough to control the banks, make

balance sheets more transparent, regulate speculative funds, and

refurbish the economy through public spending. We must remind

ourselves that the market is not a dogma; it is merely an instrument

in the service of economic progress. Liberals put liberty in first place



as a creative force that multiplies opportunities for everyone. A return

to those classical principles—principles that call for responsible

stewardship of both human and natural resources—must become part

of our future.

(This essay is the result of an on-going conversation with a number of

liberal thinkers and politicians, especially Beatrice Rangoni

Machiavelli, Frits Bolkestein, Ricardo Lopez Murphy, Vince Cable,

Josep Soler, Steingrimur Hermannsson, Carles Gasòliba, Cecilia

Malmström, Harald Klein, Gordon Lishman, Graham Watson, Neelie

Kroes, among others, who have made available their thoughts,

information, speeches and publications on this matter. Thanks also to

Nikola Spatafora, senior economist at the IMF for his valuable

contribution. My thanks and acknowledgement to all of them, and to

the members of the LI secretariat, under Emil Kirjas, for their help. A

particular acknowledgement to Lord John Alderdice, President of

Liberal International, whose trust and friendship has guided my steps

in LI these past four years and who is primarily responsible for my

attempt to write this essay. Of course, the conclusions and opinions

expressed in this document are those of the author and they do not

reflect the position of LI or any of the above mentioned thinkers. This

essay just pretends to be food for thought at the 182nd Executive

Committee of Liberal International)





Appendix I

Origins of the crisis

• Unparalleled expansion and unbridled optimism.

In the 30 years prior to 2008, the global GDP grew 5.5

times and trade was multiplied by 10 (Lopez Murphy). The

IMF characterizes this as the highest global growth in

recorded history. This longest expansion span since World

War II gave rise to unbridled optimism, leading to an ever

less cautious way of handling the economy. The effects of

opening up China and the emerging economies of Asia,

the East of Europe, and, to a lesser extent, the rest of the

developing world, to the world economy compounded with

outstanding technological advancements in production—

in the fields of telecommunications, IT, and biogenetics

particularly—led experts, politicians and the general

public to rely on a sense of ever-lasting prosperity,

justified by what appeared to be a never-ending economic

expansion.



• Lack of perspective of the economic profession.

Professionals in the fields of economics and finance forgot

the lessons of the Great Depression of the thirties. The

historical cut created by World War II made all events

prior to that event appear somewhat alien to modern

economic analysis. The joint and simultaneous

occurrence of a sharp drop in the value of assets and in

capital inflow, as occurred in the 1930s, seemed

impossible. Explanations for the enormous increase in

the value of assets were derived from the idea that the

potential for growth was extraordinary and, based on

experience from the 1940s, that the economic system

would automatically compensate for any correction that

might occur (Lopez Murphy). It is sobering to realize that

most economic analysts and commentators failed to

consider the risk of a profound and durable crisis such as

the one that has occurred.

• Blind belief in the strength of large financial and

economic institutions.

The sheer size and reach of many highly well-appraised

financial institutions, such as Lehman Brothers,

convinced many specialists of their invulnerability.



Consequently financial markets and regulators

disregarded the dangerous risk-taking activities practiced

by these firms. As events have demonstrated, regulatory

norms did not prevent these mammoth financial

institutions from assuming unsustainable levels of risk.

• Failure of statal regulatory supervision.

The quality of practical supervision of the risk-taking

activities of most financial firms by the structures of most

states has been proved dismally insufficient. In some

cases, these structures were almost ineffectual.

• Incapacity of management, boards, and investors to

assess real risk.

The value of assets and credits being traded, in structured

products, being assigned by financial institutions was

biased by expectations of short-term gain and general

optimism in the economic outlook. Little attention was

given to actually understanding the composition and real

value of many acquired products. The Spanish banker

Emilio Botin coined the phrase “If you don’t understand

it, do not buy it,” but this was not the dominant way of



thinking for most decision-makers and investors in the

financial world.

• Accumulation of public and private debt.

In an environment of expanding optimism, debt-

accumulation exercized a destabilizing effect on the

economy. In the US, subprime loans allowed people

without the usual financial qualifications to buy houses

and investors bought securities backed by these loans.

Investors also snapped up high-yield corporate debt,

“junk bonds,” driving the spread between junk bond

yields and US Treasuries down to record lows. During the

subprime melt-down, the difference between the yield on

B-rated corporate bonds increased from 2.45% to 4% in

just two months.

• Contagion effect.

The globalization of markets as well as economic and

technological interconnections increased the scope and

reach of the crisis.

• Lack of preparation among monetary authorities.



Monetary authorities reacted to early symptoms of the

crisis in a surprisingly sluggish manner. The fall in the

value of assets, and the corollary effects on consumption

and investment, happened long before they took any

coordinated action against deflation.

• Low interest rates and high world growth.

For seven years, low interest rates had prompted

investors around the world to search for yields further

down the credit quality curve. A combination of high

growth and low volatility led them to over-optimistic

assessments about the risks they were taking. Partly in

response to demand, the financial system also developed

new structures and instruments that seemed to offer

higher risk-adjusted yields, but were in fact more risky

than they appeared (IMF).

• Failure of market discipline.

While optimism prevailed, due diligence was outsourced

to credit rating agencies, and the compensation system in

the financial systems was based on short-term profits,

which reinforced the momentum for risk-taking (IMF).

Counterparties and collateral in credits that were later



sold in structured financial products were not assessed in

depth. Probes of the nature of assets being traded, and

especifically the default risk, were grossly insufficient.

• Lack of checks and balances.

Checks and balances were not invoked at the right time

and the right location. Loan brokers did not screen risk

appropriately; end-investors and their analysts did not

apply due diligence in checking the soundness of what

they were buying. At the same time, because regulation

and supervision were centered too much on individual

firms, the risks within the whole system were not

assessed correctly from a global perspective.

• Size and centrality of the shadow banking system.

As a site of innovation beyond the stricter controls applied

to the deposit-taking institutions, and as a way for banks

to evade capital requirements and proper assessments of

risk, the shadow banking system became a major risk in

itself. Its failure could provoke an economic melt-down

that could only be avoided by shoring it up with public

funds. The concentration and interrelation of firms (be

they banks or shadow banking institutions) that have



been “too-big-to-fail,” to use the currently accepted

expression, has masked the underlying risk and the toxic

assets in the complexity of both the structured financial

products and of the firms themselves. Size is an issue in

this crisis.

• Rating agencies.

The rating agency practice of giving advice on how to

structure products they must rate in order to get a better

rating has rightly been called into question as improper

and an obvious conflict of interest. Practices including

over-optimism, too-big-to-fail firms, under-appreciation of

firms, advice sold on how to structure products to

maximize ratings, and inadequate assessment of default

risk, resulted in inacurate credit ratings. Investors too

intent on realizing ever-growing short-term profits did not

question these ratings and took them at face value.

• Compensation schemes.

Firms provided incentives to maximize profit in a short

amount of time, encouraging managers to become more

tolerant of risk. Bonuses and other compensations do not

account for unassumable risks transformed into losses



down the line. A hit-and-run culture developed in which

the firm’s overall sustainability became less important

than short-term growth and profits.

• Procyclical regulatory practices and regulations.

Procyclical regulations magnified the crisis. Specifically,

most loan loss provisioning rules are based on incurred

rather than expected portfolio impairment. They

recognize risk too late and allow excessive risk in the

upswing.

• Accounting practices.

Most economists consider the transparency required by

Fair Value Accounting practices to be a good thing. But it

raises the net worth of a firm during upswing cycles,

allowing it to take on additional debt and leverage. On

the other hand, it devalues net worth in illiquid times,

such as this crisis, compounding the problems.

• Macroeconomic settings.

Macroeconomic settings in place prior to the crisis help to

explain its magnitude. An extremely stable and growth-



oriented economy existed in most of the world (high

productivity, stable inflation, low long-term interest rates,

high saving rates for Asia and oil-producers, net capital

inflows in the United States and in Europe), and it fed the

search for high-yielding risky assets. Benefiting from the

low interest rates and the limited volatility, stock and

housing prices went up. The central banks failed to

assess the growing risk while they concentrated on

managing inflation and aggregate activity. They believed

that the rules and regulations already in place were

sufficient to give warning and prevent the build-up of risk.

They also thought that low interest rates would take care

of any drop in activity if the price of assets were reversed.

Furthermore, in many states, the inability to reduce

budget deficits in times of growth to prepare for a fiscal

stimulus in times of crisis has not helped to address the

crisis.

• Global imbalances.

The US has accumulated a large account deficit, while

China, the rest of Asia, and oil-exporting nations have

account surpluses. Large capital inflows towards the US,

and to a lesser extent towards Europe, have caused

concern. Should they be subject to a sharp reversal, it



would cause headaches for the host economies and

undermine the dollar, which continues to be the currency

of reference. Although the concern has not been realized,

imbalances have kept interest rates low with a

subsequent effect on the appearance of the crisis.

• Poor forecasting ability on the part of international

financial organizations and governments.

The difficulties encountered in coordinating a response

during the first months after the start of the crisis speak

unfavorably about the capacity of the global financial

architecture to predict, prevent, and respond rapidly to

crises. International financial institutions have done a

mea culpa for failing to assess and adequately give

warnings about the form and shape of the current

situation. One of the problems in financial surveillance is

the fragmentation of data, data analysis, and sharing

information between international financial institutions

and within institutions. Also, efforts on the part of

multilateral organizations to shape action towards early

signs of the crisis have been curtailed by the inability of

participant states to take policy action quickly and in a

coordinated fashion. In many cases, they preferred to



focus on home markets at the expense of a coordinated

response that might have been more effective. This

difficulty shows the lack of leadership afforded by the

international community to some of the Bretton Woods

institutions.

• Cross border resolution and burden sharing among

national regulators.

Once the crisis started, regulators experienced difficulty

sharing burdens across borders that impeded resolutions.

This problem illustrates the lack of a coherent cooperation

and information-sharing system among supervisors in

times of crisis.

• Access to adequate liquidity and financing.

For many countries, large and small, the problem of

adequate liquidity and financing surfaced at the onset of

the crisis. The IMF and other international financial

institutions have faced a situation in which broad

liquidity insurance has been insuficient.

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The World Economic Crisis - Alliance of Liberals and ... · Liberal International - The world economic crisis Prepared by Juli Minoves-Triquell, LI Vice-President in the Bureau 5